Tuesday, October 11, 2016

Some comment on the Twitter buyout rumours

Twitter is wildly addictive. This is well known and there are people who check twitter more obsessively than anyone checked email.

Twitter is also a chaotic world full of trolls, useless information, porn-spam and videos of kittens.

It is also - as anyone cares to notice - for sale.

The gossip - and I have no reason to doubt this - is that there are on the Twitter board two factions:

The CEO Jack Dorsey who wants to run the company and

The board who - sick of pointless losses and running out of money - wants to sell it.

This leads to probably the most leaky sales process I can ever remember - with almost daily rumours about who is interested and who is not interested. The current rumour mill says all the "strategic buyers" are not interested.

In this blog post though I just run through the numbers and try to delineate what as a regular user (but an outsider) should be done. But I will cut to the chase now. This company should be and probably will be bought by an aggressive financial buyer. And Jack will be fired. (And - I think - the world will be a better place for that.)

Just the numbers

You can find time series quarterly P&Ls (standardised by Thomson Reuters) here. An annual series is below.

Period End Date

31-Dec-2015

31-Dec-2014

31-Dec-2013

Revenue

2,218.0

1,403.0

664.9

Net Sales

2,218.0

1,403.0

664.9

Total Revenue

2,218.0

1,403.0

664.9

Cost of Revenue, Total

729.3

446.3

266.7

Cost of Revenue

729.3

446.3

266.7

Gross Profit

1,488.8

956.7

398.2

Selling/General/Admin. Expenses, Total

1,132.2

804.0

440.0

Selling/General/Administrative Expense

892.3

583.7

270.5

Labor & Related Expense

239.9

220.3

169.5

Research & Development

806.6

691.5

594.0

Total Operating Expense

2,668.1

1,941.9

1,300.7

Operating Income

(450.0)

(538.9)

(635.8)

Interest Expense, Net Non-Operating

(98.2)

--

--

Interest Expense - Non-Operating

(98.2)

--

--

Interest Income(Exp), Net Non-Operating

--

(34.0)

(6.9)

Interest Inc.(Exp.),Net-Non-Op., Total

(98.2)

(34.0)

(6.9)

Other, Net

14.9

(5.5)

(4.5)

Other Non-Operating Income (Expense)

14.9

(5.5)

(4.5)

Net Income Before Taxes

(533.3)

(578.4)

(647.1)

Here is what to notice. Revenue has gone up very nicely - from $664 million to $2.2 billion and is still increasing. And costs have gone up commensurately. Losses seem stubbornly stuck at half a billion per annum. That is real money - just burnt - and burnt by a business that is already established.

In other words costs have gone up by $1.5 billion give or take something. That is billion with a b.

Now if costs were rising that fast and the service were noticeably improving and engagemet growing then you could be tolerant. Making money is far less important in a growing tech company than increasing your relevance and the moat that surrounds your business. (Amazon is the leading example of a company which increases the moat every day.) The short-hand for that thinking is that revenue follows relevance.

But - as a pretty dedicated tweeter (with almost 20 thousand followers) - I have noticed almost no changes in twitter that improve my user experience. It is almost impossible to find out what they spend that $1.5 billion extra per annum on. I gather there are some improvements in the monetisation side but this is just a website - and it does roughly what it did in 2012 - and but spends well over a billion dollars more to do the same thing. [From my perspective the marginal improvement is that I am seeing fewer failed-to-load pages... but that is it.]

Twitter has become a parody of bad Silicon Valley management - the sort of management that existed in the dot-com boom where quite literally burning shareholder funds was considered a mark of innovation.

The main difference between this and (say) Pets.Com is that underneath is a business that should be salvageable - and should make pot-loads of money. After all if they raised costs by $1.5 billion per annum without achieving jack-shit then costs should be able to be controlled. And if that is possible then Twitter as an LBO works on the back of an envelope at these prices.

Why a financial buyer not a "strategic buyer"

The news of the day is that almost all of the strategic buyers (other big tech companies) have pulled out of the bidding process. There is good reason why that should be the case.

If you run Salesforce.com for instance your main agenda should be on growing your business in a disciplined fashion. They are still in the stage of building relevance. And that requires friendly well directed management willing to let staff have their little well-directed flights of fancy (rewarding of course those fancies that grow the business).

But Twitter is past that. Somewhere near half a billion dollars of costs need to be taken out almost immediately. And that involves firing people and being a general tough-bastard. It's inevitable anyway - because Jack Dorsey burning half a billion dollar per year isn't a sustainable business. The cash eventually runs out.

The problem is if you mix this with a Salesforce.com or similar company it will be really hard to take costs out in a disciplined fashion without upsetting the culture of the home company. Instead this should be fixed (with extreme prejudice by a disinterested outsider) before it is sold again to a strategic buyer.

Or - in summary: the best bastards are from Wall Street. And this needs a Wall Street bastard.

Carl Icahn - Twitter needs you.

--

That said - there are things that need to be done that are not being done under the (seemingly incompetent and fashion obsessed) Jack Dorsey.

First troll detection has to be done much better. There degree of incompetence in troll-hunting beggars belief. For example I have stereotypically attractive 20 year olds in bikinis who just want to do wicked things to me (and I am not even Donald Trump). I block them all and report them - but somehow Twitter has not managed to stop filling my time-line with porn spam. Blocking this is the sort of pattern recognition that computers should do - and if your spam-to-content ratio gets to high you eventually lose real users.

Also there is a lot of semi-commercial (even scam) spam here. Have a look at this twitter stream: https://twitter.com/doxitehydyla.

There are almost 10 thousand tweets - and they are all penny stock promotion mostly for the same penny stock. I think it is Russian but the location says Manchester. (Many scam promotion schemes look the same - and I do not think the penny stock promoters all live in Manchester.) The Tweets include a reference to some hot stock or controversial stock (Apple, Herbalife etc) and then links to a penny stock page. It is really obviously spam. But it has been around for months.

It also has 800 followers and not a single overlap with my followers. In other words almost all the other followers are spam bots too (because I seem to have overlap in followers with all serious financial tweeters).

I could block five of these a day and there is still an endless supply. It makes searching for news about a stock almost pointless because the ratio of spam to real news is not good.

I suspect the management incompetence goes further. If they actually fix the spam-bot problem then the truth about the active users numbers will out. It is weak (precisely for the reason above). But weak numbers mean they are all going to need to be fired.

--

But lets play the numbers

Twitter revenue is still rising and is running about $2.5 billion per annum. It is a website that once ran extremely well on less than $250 million in costs. (No I am not joking.)

If you can't make this have a 40 percent operating margin then - frankly you are inadequately brutal. Personally I think 50 percent is possible.

At this market cap that works extremely well for a financial buyer. Its a no-brainer even.

So expect it to be bought. By some Wall Street bastard armed with a lot of debt.

And that bastard will fire a lot of people.

If I worked at Twitter I would be preparing my resume and providing a list of really quick things that can be done to improve the user experience - with the code all mapped out. That largely involves getting rid of spam bots and the like. But unless it radically improves the user experience or monetisation and you can convince the new owners you can implement then you are out.

And the fashion-obsessed philosopher king. He is out too whether there is a buyer or not. That is necessary to save the company.

Great Piece, considered a job there 3 years ago in Dublin and couldn't rationalise the approach with the goal - profitability.

Whilst dealing with bots could we also suggest the other side of the coin - fake (bot) followers.

These can add credibility and back up a storyline with little or no real substance - look at the WB21 story on Alphaville last week, both the CEO and company have 185k followers - perhaps not surprising for a company with a million customers if you a non tech angel looking at investing, a lot if your understand fintech and wonder about the business??

Fake followers and tweeting bots really affect the credibility of the provided service.

Well argued as usual. The question is how the overhang resulting from the appalling management culture would affect the possibility of generating what under normal circumstances should be high operating margins. I've only had a quick look but the fact that R&D expenses seem to contain 400m in stock based comp in 2015 alone tells you something. It's time someone does something about it, but is this the kind of company that is ungovernable outside crazy silicon valley standards?

Stock based comp in 2015 was close to 700m with another 1.25bn outstanding. R&D bore 400m out of the 700m and Noto famously received a package worth some 72m to manage what is frankly a simple business model. An obscene, shareholder funded party. It really is time someone cleans this up. The only thing I wonder is if this kind of tech company is manageable outside fantasyland-silicon valley norms, as this insane culture seems deep-rooted in the business.

Nice article again John, was wondering if the extra 1.5bln in costs may have something to do with the technology required to live stream events such as NFL and the recent presidential debates which is the only bit of "innovation" i have seen from them since I have started using twitter (@verybearish) I literally have no clue how expensive it is to do create (or just piggyback on existing) tech to do this, also i wonder is it a one-off type expenditure or in need of constant maintainance( my guess the latter).

Not a wall street bastard, but a Tech PE fund like Silverlake. You cant just slash costs, you have to have a management team that knows how to improve user growth and monetization. Then you have to reset all the crazy stock awards. If you take 2.5B * 0.3 Net Margin * 20 multiple = 15B. Assume 50% growth over three years and an IPO at $25B, maybe. A real premium only comes from a story than can get user growth or monetization moving and I havent heard it yet.

Well reasoned, between the absurdly high R&D, which has given users nothing and the even more absurdly high stock based comp, which also has produced nothing, there is clearly a path to profitability that can be achieved by a crack new management team. Noto and Dorsey BOTH need to go.

Um, you could have said the same thing about YHOO, which was taken out at a much lower purchase price (under $5 billion and now they want a discount!) than where Twitter currently trades. Yahoo! had higher revenue. It has largely been proven by Yahoo! that milking an Internet business for cash doesn't ultimately work - albeit Yahoo!'s recent management tried to reverse the process and just made things worse.

@verybearish (comment up above re video streaming infrastructure costs) - companies such as Brightcove and Akamai have been providing video streaming platforms at global scale for a long time. It is becoming increasingly commoditised eg. see Google Cloud just acquired Anvato. If TWTR are spending a lot on building this themselves they're doing it wrong. There isn't much in the technology itself which differentiates - it's the way they link it into the broader ecosystem.

1) They are not burning cash with the exception of using it acquiring smaller companies. Most of the expense is on stock-based compensation (non-cash). So they can survive without raising capital or debt.

2) Agree that they can be very cash positive for acquirer like Salesforce or Google, which both has the engineering team to cut these expense down.

3) Most of the expense most likely went to build-out for advertising side of the business (real paying customer). So they can track stats on their ad dollar more accurately. Also agree they should balance out the need of the content/tweet providers.

Mind you, TWTR is profitable on adjusted basis, so there's no "cash" loss at the company. Sure, investors are getting diluted left and right, but the company is still profitable on cash basis (and has been expanding margin).

But I guess it still holds true that someone could come into slash stock expenses massively (and perhaps other costs), which will definitely require a heavy-handed restructuring.

Part of the issue is actually a general hiring of talent in SF/Bay Area which are in reality pretty mediocre. Barring engineering talent, I would say there a lot of folks in non-engineering roles at Twitter who happened to be at the right place at the right time (previous tech experience to give some legitimacy, and no visa issues).

Twitter reminds me of Zynga, which in its heyday back in 07/08 had amazing revenue ramp and hired too aggressively. In Twitter's case, it doesn't have this inherent need to acquire games like Zynga, so I agree with your sentiment on what the extra opex has actually contributed to.

Silverlake would be a good candidate for a take private, or perhaps a SWF like Temasek / CPPIB. Might also be an interesting target for Jesse Cohn at Elliott too ...

A rising tide lifts all boats, but it's only true talent that survive when the tide recedes...

There is big money to be made in TWTR and it starts with big changes to the company culture, which means new management. Jack has zero interest in pleasing shareholders, which is clear by listening to 5 minutes of a conference call. When it comes to shareholder interaction and transparency, he does the bare minimum. Why? because he still believes Twitter is his company, and that it exists to make the world a better place, not necessarily to make money. While that is a noble opinion, any public company's CEO should not put their personal agenda of what is best for shareholders. Jack is clearly a talented man, and a tremendous entrepreneur. But a good manager he is not. Jack lacks self-awareness. And he is able to perpetuate his self-image by over paying employees and asking for little production. In return he gets their praise and a happy #whyIloveTwitter culture with 3500 employees that spend a lot of their time patting each other in the back. They believe everything is great until reality hits, at which time the motivated ones leave for a better opportunity, and the mediocre ones stick around, get their options repriced and look for someone to congratulate on a job well done

Bottom line, the current environment at Twitter is one of complacency (the opposite of urgency). Twitter needs a culture that stresses hard work and accountability. That has to come from the top. Jeff Bezos makes his employees work super hard and they are held accountable. Apple does the same. And, a more relevant comparison is Evan Spiegel at Snapchat. He is as cutthroat as they come. What does that get you? Well Snapchat recently valued at $25 billion (two Twitters) and they have 300 employees (1/10 of a Twitter). Hummmmmm, I wonder why they are doing so well? The answer is clear.

Twitter's main problem seems less a matter of cash burn since it earned for the first half of this year about $275mn in free cash flow after capex and has about $2.1bn in net cash.

Its main problem is that its ROI on R&D investments have been low. Like much of Silicon Valley's outputs, Twitter is not a business (yet?); it's a product.

If it expands the market for its current product, partly by improving it; diversify itself into a business (since the product is showing slowing growth) or both, it could survive as a standalone enterprise.

If it comes up short on all these options, there's a good chance it will become "takeunder" fodder, however, at much lower prices. Projecting forty to fifty percent operating margins seems high for a business that needs to continually invest if it doesn't want to become irrelevant.

Even at fifty percent operating margins, or $1.25bn, today's $13bn equity market cap seems too high for a business that has active-user growth on the verge of declining.

I agree with your analysis entirely except the conclusion.A strategic buyer will be able to realize the benefits of an effective cost reduction strategy while synergizing revenue-adding strategies through cross-selling (i.e. google or fb selling ads on legacy platforms bundled with twitter ads).All of the benefits for a financial buyet that you aptly point out could be better realized by a strategic buyer.

If Twitter can generate $1.25B in earnings a year, what is the right valuation and why?

Assume growth and engagement continue on their current course, the R&D money has been wasted, and Silverlake or a "Wall Street bastard" comes in and slashes costs and waste, but also fixes the troll problem, fake or useless bot accounts, and other low hanging fruit.

Q3 guide is for 5% y/y revenue growth and Q4 compare is difficult so their upcoming guide could easily be for shrinking revenue. MAU's appear to have topped as well and this is during what could be the most polarizing election in history. So what is the right price to pay for an asset with flat-to-down revenue and user growth? Your $30 target implies ~9x sales - LNKD is an infinitely better asset and sold for less. The idea that this is a cost-out story ignores the bigger issue - that the revenue model is broken and the company is rapidly losing share to deep-pocketed competitors like FB/GOOG and nimble upstarts like Snapchat. My guess is that the stock drops ~40% before getting acquired by a strategic and perhaps even further if share loss accelerates. The YHOO comparisons are far more apt for this business than FB. Why own this stock on the basis of praying for a takeout? Hope is not an investment thesis.

You might want to join the efforts to #BuyTwitter and turn it into a #platformcoop, see here http://internetofownership.net/2016/10/04/a-guide-to-buytwitter/ for links to Slack channel and Loomio group :)

I find your main premise hard to accept - you are saying that strategic buyers are too 'nice' to make the necessary cuts to make Twitter profitable and that only financial sponsors are able to do this.

Whilst sponsors are certainly more ruthless in order to meet their returns profile, I believe that the ONLY potential buyer is a strategic one.

Twitter is currently valued around $13.5B by public markets. With a modest 20% premium attached this raises the price to $16B. I doubt even the largest PE funds would be willing to risk allocating this much capital to what remains a very risky business, no matter the cost savings available.

A strategic buyer would be able to achieve cost and revenue synergies with their existing platform (e.g. Google integrating tweets in searches) and could justify an acquisition much more easily (although I doubt that Google are interested at the current price).

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